Using the Capitalization Rate to Determine the Value of Real Estate

Capitalization rates, sometimes referred to as cap rates, help you analyze investment real estate returns. Unlike other analysis methods that base a property's value on its size or gross rent, cap rates take the property's net income into consideration. While cap rate-based values are easy to determine -- simply divide the cap rate, expressed as a percentage, into the property's net income -- the factors that go into using them can be more complicated.

A Detailed Analysis

The math behind the cap rate is relatively simple. If you have a $150,000 house that generates $10,000 in net operating income, it carries a 6.67 cap rate. You also can flip the equation around to find values. A house generating $9,000 of net income in an 8.5 percent cap rate market would be worth $105,882. This comes from dividing 0.085 into 9,000.

Generally speaking, high cap rates are good for buyers, because it means that they're getting a higher return on their invested money, while low cap rates are better for sellers, since it means the buyer is paying more for the money that comes out of the property.

Net Operating Income

Net Operating Income is a key component of the cap rate. A Net Operating Income should include all of the income generated by the house such as rent and forfeited security deposits. From the income, you subtract a vacancy factor and expenses like utility bills, management fees, repairs, property taxes and repairs. NOIs exclude major capital repairs like new roofs, depreciation, the cost of financing and any personal expenses like mileage.

When using cap rates to value and compare properties, one of the challenges is that different investors include different things in their NOIs. If you have one property that includes a vacancy factor and a management fee and another that doesn't, the latter property will appear to have a much higher income and a much higher value. As such, it's important to dig into the NOI to understand what, exactly, it includes.

Choosing a Cap Rate

When you're valuing an investment, you'll need to make a judgement call when you select a cap rate to divide into the NOI. Looking at recent property sales on the basis of their incomes can give you a good sense of the overall average, although you'll need to remember to adjust the incomes so that the NOIs are all calculated the same way.

You also may need to adjust the cap rate up to drop the price a property that is less desirable than the market as a whole. Very desirable properties or houses that have room for rental increases could be marketed at a slightly lower cap rate, giving them a higher price.

Actual vs. Pro Forma

The cap rates that you use to value a property tend to come in two types. An actual or current capitalization rate looks at a property's actual NOI with the income and expenses that are in place. Pro forma cap rates use an NOI that represents how the property should be able to perform for a new buyer.

While using an actual cap rate may understate the value of a property that is rented below market or poorly managed, using pro forma cap rates could leave you vulnerable to overstating the property's value based on unrealistic, pie-in-the-sky assumptions.